part0024

This book is primarily about growth stocks, but a chapter has been spared for cyclicals as all companies are cyclical to a greater or lesser extent. The term ‘cyclicals’ usually refers to those stocks that are particularly sensitive to the ups and downs of the economy as a whole.

One of the biggest single influences on the economy is the level and trend of interest rates. Cyclical stocks benefit most when interest rates are falling as, in due course, that usually stimulates the economy. Conversely, in times of rising interest rates, cyclical stocks fare very badly.

All companies do better when the economy is prospering and find the going tough when it is in the doldrums. However, even in the worst trading conditions, great growth companies still manage to turn in increased earnings per share year after year. Their rate of growth may be slower than their long-term average, but growth will still be a continuing feature. In contrast, cyclicals, such as steel producers, paper manufacturers, automobile manufacturers, housebuilders and chemical companies, react more violently to changes in interest rates. Often they make substantial losses during severe depressions and have difficulty in surviving until the next boom. When and if they finally recover, the swing from losses to profits is often far in excess of expectations.

I much prefer growth stocks as a steady diet, but there is no doubt that in some years cyclicals outperform them by a wide margin. Fortunately for me this happens infrequently but when cyclicals are in vogue it can be very hard going for growth investors to produce their usual outperformance.

Pinning down exactly when it pays to invest in cyclicals is obviously crucial. Credit Lyonnais Laing, the stockbroker, prepared a very interesting circular in late 1994, setting out the circumstances required for cyclicals to outperform non-cyclicals. The table below is an extract from their excellent research:

As you can see, the best years for cyclicals were 1983 (+12.8% against -5.4%), 1985 (-2.5% against -4.1%), 1987 (+0.2% against -4.1%) and 1993 (+26.2% against -13.1%). In the other eleven years cyclicals underperformed non-cyclicals, emphasising that to be successful with cyclicals, it is vitally important to get your timing absolutely right.

The CLL circular shows that falling interest rates were a key factor common to the four most successful years for cyclicals. Looked at the other way around there was no year of rising interest rates in which cyclicals performed well.

In three of the four best years for cyclicals, you can also see how they performed relatively well in the last year of falling interest rates before they began to rise again.

In all four of the best years for cyclicals, sterling was also rising. It is, of course, easy to tell when sterling is rising and when interest rates are falling. The difficult point to ascertain is whether or not it is the last year of falling interest rates. Possibly the best way of determining this is to check if GDP non-oil growth is at a relatively high level. Certainly, the 4.5% growth in 1983 and the 5.3% growth in 1987 would have flashed a warning signal that falling interest rates were at an end and a rise was imminent.

In the best three years for cyclicals, 1983, 1987 and 1993, interest rates had already fallen during the previous year and in 1987 and 1993 for several years before. It seems therefore that the first year of falling interest rates is unlikely to be right for cyclicals. 1985 was a minor exception, but their outperformance was so trivial that it can be ignored.

Before selecting a cyclical share, it is probably a better idea to pick an industry that is due for a rebound. The second step is to pick one or more companies that seem to be particularly attractive. The largest companies in the industry are likely to be safest; the smaller ones will usually offer the biggest percentage gains but they are also far more likely to go to the wall.

Peter Lynch says that when considering whether or not to buy shares in, for example, a leading copper producer, he would prefer the opinion of a plumber who knows what is happening to copper prices, to that of an MBA who thinks the shares a buy because they look cheap. In fact, the lower the multiple of a cyclical, the more dangerous it is to buy – a share that looks cheap may in fact be very expensive indeed. A very high multiple usually signals the bottom of the cycle, whereas a very low one can be a warning that the end of the upturn is nigh.

When investing in cyclicals you want the industry and your chosen company within it to be surrounded by gloom and doom. The PER may be very high, but the newsflow could be beginning to turn positive and the relative strength of the shares should be beginning to pick up. If this is happening, it often pays to grit your teeth and pay up to get hold of the stock.

There is another very important fundamental factor to consider – the strength of the company’s balance sheet. A substantial positive cash position is obviously very reassuring, as is strong cash flow. However, even if the company has massive borrowings, it may still be all right provided the newsflow is turning really positive. A rights issue may be necessary, but at least the company should survive.

The time to really worry about inadequate cash is if you buy into a recovery stock when trading conditions are still deteriorating or, at best, static. I do not recommend this approach, but some investors shoot for a really big gain by trying to invest right at the bottom. If you are determined to play cyclicals this way, I suggest that you at least ensure that the company’s balance sheet is strong. This will give you a longer time to be proved right.

With a cyclical, the price-to-book value is always of interest. The net assets of the company are the raw material to fuel the recovery. Obviously, any company standing at a substantial premium to its book value is far less attractive than one standing at a massive discount.

Similarly, a very low price-to-sales ratio gives an excellent indication of the scope for future recovery when the industry picks up and margins begin to improve. For this reason, it is always worth trying to establish normal peak margins for the sector and to compare them with present levels.

I have mentioned a few times the magic word ‘newsflow’. It does not only refer to announcements about profits and dividends. It also embraces such items as factories being sold or closed, major redundancies, large orders being secured, appointments of new directors and the like. A new chief executive can often be a major turning point for a company: Archie Norman at Asda, Gerry Robinson at Granada and Lord Wolfson and David Jones at Next, to name but a few. However, newsflow does not have to be so dramatic; it just needs to be becoming more and more positive. It is the trend of newsflow that is the main influence on the share price.

As always, a cluster of directors buying a significant number of shares is very encouraging. With a cyclical it is arguably even more of an endorsement than usual. If the company is, in trading terms, right at its low, there is a risk of it failing altogether. In that event, the directors would lose their jobs as well as the capital they have already invested in the company’s shares. To add to their downside risk by buying further shares, shows that they are very confident indeed that the company will recover fully.

a) The second or subsequent year of falling interest rates seems to be a far better bet than the first year.

b) Sterling should be rising.

c) The last year of falling interest rates is optimum. If growth in non-oil GDP rises to 4% or more, the chances are that interest rates will rise in the following year.

2. Do not buy cyclicals blind. Try to find someone who is in the industry or knows a lot about it. Read as much general information as possible about the industry.

3. Treat low multiples with caution. They may indicate trouble on the horizon.

4. Do not be frightened of high multiples provided the news from the company is beginning to turn, even very slightly. The trend of future newsflow will be the main influence on the share price.

5. Prefer companies with a strong cash position or one that is improving quickly.

6. A substantial discount to book value and a low PSR can be encouraging indications of the scope for future recovery.

7. Watch the relative strength of the shares carefully. If this is beginning to turn positive, it is usually an excellent sign, especially after a major downturn and long period of consolidation at the lower level.